The Pros and Cons of Universal Life Insurance

Universal life insurance has both advantages and disadvantages. We cover both the pros and cons to help you decide whether universal life is best for you.

Every once in awhile, I will receive financial questions from readers. Now, I am not a financial adviser. I usually suggest those needing significant assistance with their financial decisions to seek the advice of a professional. However, I don’t mind answering general questions that might be helpful for a wider audience. I also solicit help from the site’s other writers who may have more knowledge than I on a particular subject.

Today’s question focuses on a topic that I don’t usually cover: life insurance. Specifically, they wanted to talk about universal life insurance, which is a bit of a controversial topic in personal finance circles.

Here’s the question a reader sent in:

I recently read a book called Tax-Free Retirement by Patrick Kelly. In it, the author was selling the idea of buying Universal Life Insurance as a way to build your retirement fund. I’ve been doing research on Universal Life Insurance (pros and cons). What are your thoughts on Universal Life Insurance, and is it something you recommend people buy?

What is Life Insurance?

Let’s take a moment to talk about the many aspects of life insurance in general. Then, I will circle back to address the specific question about universal policies and retirement funds.

So, there are three primary parties when it comes to insurance: the insured, the beneficiaries, and the insurer. Life insurance policies are offered by the insurer to protect the income and earning potential of the insured.

If the insured passes away, the beneficiaries — who relied on the income of the insured to some degree — can continue with a comparable quality of life. This may be in the form of receiving regular income (through a trust) or even getting a lump sum payment.

For example, the head of a household (or all income earners in a family) may buy life insurance in order to protect the needs of their children. This coverage could ensure that the children have their everyday needs met, as well as provide for future education expenses, healthcare, and the like.

Life insurance benefits could also help pay for funeral costs, medical bills, and any outstanding debts (such as a mortgage or joint credit card debts) that the insured may leave behind.

Types of Life Insurance

Term Life Insurance

Life insurance comes in several flavors. The most common, and the most basic, is term life insurance.

This is a typical insurance policy, where coverage is based on a set number of years. During that period, the insured will pay premiums and be protected. However, at the end of the term, the protection ends.

While term life insurance gives you the most bang for your buck, the nature of it means that someone could essentially pay into a policy for several decades without a return. If that insured individual continues to live and stay healthy, he or she will never receive any benefit from their term policy, other than peace of mind.

At the end of a policy term, insurers typically offer an option to renew the policy. However, depending on your age and any health changes, your premiums are likely to go up with renewal. This is why term life insurance is more ideal for younger, healthier adults, when their risk of death is lower.

Related: How Much Life Insurance Do You Need?

Of course, the idea of paying into a policy for years without receiving any benefit didn’t sit well with many. So, insurers eventually came up with different types of policies.

Permanent Life Insurance

These alternatives are often called permanent life insurance policies, and there are several different plans designed to suit a customer’s needs. Universal life insurance is one form of permanent life insurance. Whole life insurance is another.

These non-term policies usually include a savings or investment component in order to help insurers mitigate some risk. That’s because, in these permanent policy scenarios, the chance of paying out benefits is closer to 100 percent. This component can make them a very tempting choice when shopping for life insurance, but let’s take a deeper look before you make any decisions.

What Is Universal Life Insurance?

Universal life insurance is a type of permanent policy that can provide coverage for the remainder of your life. You won’t have to worry about renewing the policy every five, 10, or 20 years, as with term insurance. However, if you want to cancel at any time, you’ll actually have the opportunity to cash out on some of the money that you paid into the policy.

These policies often cost considerably more than term policies of the same coverage amount, but provide some flexibility in the premium payments over time.

Premiums, in case you don’t know, are the amount of money that the insured pays to the insurer for the coverage, usually on a monthly basis. The unique thing about permanent life coverage, though, is that a portion of these monthly payments also goes toward funding each policy’s savings component.

The savings component is the cash value portion of the insurance policy. It’s basically a savings account from which the insured can withdraw or borrow money over time. They can even use it to reduce or skip their policy premiums when needed. The younger and healthier you are, the more money is placed in this account; as you age or as your health deteriorates, a smaller percentage of your monthly premium will go toward building this cash value.

Because of this benefit, the premiums are much higher. Sometimes, the difference in premium is a factor of ten. So, is the savings portion worth ten times more than a basic insurance policy on its own?

The Pros of Universal Policies

There are a number of reasons that universal life insurance policies are so appealing.

First off is that whole savings component. At its foundation, it’s much more ideal to buy life insurance that actually holds some value. If you decide you don’t want the policy 15 years from now, you’ll simply* be able to cash out.

*I say simply, but the ease of this policy cancellation varies. We’ll discuss this in the cons section, next.

You also have a potential nest egg built up after all of those years, which could be seen as a forced retirement savings vehicle (if you’re the type of person who needs that sort of thing).

You’ve been paying premiums and your money has been earning interest for years. If you live to a ripe old age, you have a nice chunk of change saved up, which you can either leave alone or borrow from when needed. If you don’t, your beneficiaries receive their payout, without you having to worry about renewing term policies over the years.

Another interesting benefit of universal life insurance is that the insured can use interest earned on the savings component to help pay the monthly premiums. If you get in a financial bind or want to allocate your money elsewhere for a few months, you usually can (depending on the cash value and interest earned on your policy).

One of the biggest perks of a permanent policy, though, is simply avoiding the issue of renewing term policies or shopping around for rates every few years. You can stick with one policy throughout the decades, and have one less thing to worry about. This is particularly great if you already know that you’ll need lifelong coverage in order to provide for a dependent, such as if you have a special needs child or a disabled spouse.

There are quite a few downsides, though.

The Cons of Universal Life Insurance

High Fees

While the savings component of a universal policy sounds great in theory, it may not be so wonderful.

Compared to the returns earned by your universal policy premiums, you may be shortchanging yourself. You may easily be able to generate your own returns in savings or investments that are significantly better than the returns you’d receive through your policy. You’ll also have much more flexibility with your own investments and can make your own decisions. You don’t have any say where your policy’s cash value savings are invested.

To further that note, you’ll also likely pay much higher fees for managing the investments of your universal life insurance policy. With other retirement accounts, such as 401Ks, you can find investment fees as low as half a percent or lower. Universal life policies, however, often have fees as high as 3%. This can make a significant difference in the overall growth of the savings.

Cancellation Fees

Another downside is that when you withdraw or borrow money from a universal life insurance policy,  it reduces the amount that your beneficiaries would receive if you died before repaying the loan. This alone is often enough to steer people away from this type of coverage.

If you buy into a policy and then change your mind later, you can cancel. However, cancellation isn’t easy, and can wind up costing you a pretty penny depending on how long you’ve held the policy. Be sure to read the fine print to see how much of your cash value you will forfeit if you cancel the policy in the first 3 years, 5 years, 10 years, and so on.

Mediocre Returns

Now, to what I consider to be the biggest downside of them all. Remember how we talked about universal policies being for life, versus a shorter “term” length? Well, there’s a very important caveat that could land you in some serious hot water, if you’re not careful.

Yes, universal life insurance policies can last you the rest of your life. However, this depends on the returns of those invested savings and the actual cost of your death benefits, according to your health changes over time.

As mentioned, a portion of your premiums each month goes toward your actual “life insurance coverage.” Let’s say that you’re a 25 year-old in great health paying $100 a month. Twenty dollars of that might be going toward the insurance company’s actual cost for providing life insurance for you. The remaining $80 is going into your cash value savings.

However, as you age, that number will change. When you turn 60, that split might be closer to $70 for benefits and $30 going into savings. When you hit 75, you may be in deteriorating health and those investments might not have panned out as well as the insurance company had hoped; in turn, the company may require more than $100 a month for your coverage, even though that’s your premium amount.

To make up for the deficit, the insurance company can (and will) dip into those cash value savings. If it goes unnoticed, you could realistically check on your account one day — you know, the one you counted on to be your big nest egg and provide life insurance benefits for your family upon your death — only to find it dwindled away to nothing. Decades of savings and “guaranteed” benefits, gone.

Unnecessary for Most

One final note. Most individuals do not need permanent life insurance. A retiree who has little or no earned income, for example, often has no need of life insurance. One exception, however, are families caring for disabled adult children. But again, for most families, life insurance is unnecessary after the kids have left home and retirement is at hand.

Should a Universal Life Policy Build Your Retirement Fund?

This is a tricky decision and has a lot of drawbacks. But the savings component can still make this a tempting option for many.

There are three major drawbacks to this approach that you should keep in mind before buying into a policy. Because of these reasons, I would not use a life insurance policy of any type to increase my planned income during retirement.

1. Any retirement income you need and withdraw reduces the value of the benefits your heirs will receive, as mentioned above.
2. You can get better investment options by opening an IRA at a discount brokerage.
3. You’ll be paying much more for less potential performance than other retirement options. Even a 401(k) could cost much less.

If you’re a savvy saver and investor, you may want to leave your investments separate from your life insurance policy and opt for term life insurance. If you appreciate consolidating your savings with your insurance policy and are not concerned with a significantly higher cost, it might make sense to opt for this type of coverage.

For readers: Do you have a universal life insurance policy and are you happy with the insurer so far? Have you had any experiences collecting benefits from a policy?